What, if anything, has China decided to do differently?

China widened the band around the RMB and raised (slightly) interest rates, with the rate on deposits going up more than the rate on lending. It hardly seemed like a major policy shift to me – but it attracted a lot of attention.

Widening the band in particular didn't strike me (or some others) as much of change. After all, China hasn’t made much use of its existing band. An anonymous Shanghai trader in the Wall Street Journal:

“It "means nothing" for yuan appreciation, said a Shanghai-based trader with foreign bank. "We don't even use half of the current band. This is just to impress [U.S. Treasury Secretary] Henry Paulson."

If a wider band doesn't lead to faster appreciation, I doubt Paulson — and more importantly the Congress — will be all that impressed. I liked the way Keith Bradsher of the New York Times reported the limited scale of RMB appreciation over the past two years: an initial 2.1%, and then another 5% over nearly two years.

That works out to about 2.5% a year. In other words, not much. Not when the dollar has slid against other currencies. Not when Chinese inflation has generally been lower than US inflation. Not when China’s trade and current account surplus is growing so fast.

I was, though, struck by another bit of data that came out: the 167.4b yuan fall in Chinese bank deposits in April. Deposits are expected to fall further in May. (Big hat tip, David Altig of Macroblog). That presumably is why China hiked deposit rates more than the lending rate (see Morgan Stanley's Denise Yam)

Chinese citizens haven’t exactly jumped at the prospect of pulling their funds out of the domestic banks and buying dollar and euro-denominated bonds. But they do seem to be jumping at the chance to buy into China's own market — and perhaps into China's own version of a "bubble economy."

The fall in deposits matters. The core underlying reason why China has been able to sterilize its massive reserve increase at a fairly low cost is that China’s own citizens have been willing to hold their savings in the banking system even though the banks pay a low interest rate. The government then effectively forced the banks to lend some of their cheap deposits to the central bank – typically by buying sterilization paper – at a low interest rate. In return, the banks got a fat margin on their lending, and lots of help taking their old NPLs off their balance sheets.

So long as the banks lent a rising share of their growing deposits to the central bank, a big chunk of China’s household savings was effectively locked up and sequestered abroad. That helped hold inflation down. If it now takes higher rates to draw savings into the banking system – or perhaps just to keep deposits from running out of the banks and into stocks — the government will likely have to pay the banks a bit more on its sterilization bills. That may change the government's own evaluation of the costs and benefits of its current policy. Fewer of the costs can be passed to China's households (in the form of low deposit rates).

And if the rising stock market generates a bit of a wealth effect, spurs consumption and starts generating a bit more inflation, that too could generate pressure to change.

I do hope, though, that Keith Bradsher of the New York Times isn’t accurately reporting the thinking of China’s officials when he notes that higher Chinese rates – and a smaller gap between Chinese rates and US rates – imply a smaller rate of yuan appreciation:

But raising domestic lending rates could make it harder for China to allow further appreciation of the yuan. That is because the central bank is itself a borrower. It borrows yuan, by issuing bonds, to pay for its extensive interventions in currency markets, where it has accumulated $1.2 trillion in foreign exchange reserves, mainly dollars.

The central bank earns a higher interest rate on American Treasury securities than it pays on yuan-denominated bonds at home. The authorities use this profit from the difference in interest rates to cover losses on the foreign exchange reserves, which are worth less and less in yuan as the yuan appreciates.

I sort of see the logic. The central bank thinks it can cover the capital losses associated with borrowing in yuan to buy depreciating dollars out of the interest rate spread (the “carry”).

But in a deeper sense, I don’t see the logic. The central bank has been intentionally buying overvalued dollars with undervalued yuan for a long time – that is how it has kept the yuan undervalued. It will eventually take a loss on those dollars. And the more dollars it buys to keep the yuan undervalued, the bigger the loss. In this case, I am fairly confident that the “carry” is too small to cover the expected exchange rate loss.

Slowing the pace of appreciation even more because of less carry means that the yuan’s undervaluation will last longer – and in all probability that the central bank will end up having to buy even more dollars. The central bank avoids reporting a loss today – but it adds to its future loss.

Tell me again what China’s exit strategy is?

Stephen Green of Standard Chartered thinks China will run a $400b current account surplus this year, and an even larger surplus in 2008 and 2009. $500b isn’t out of the question. Others have a slightly smaller estimate, but nearly everyone thinks China is set to run large ongoing current account surpluses so long as it maintains its current policy constellation.

If China's government is unwilling to allow the yuan to appreciate by more than the interest rate differential, isn't it just locking itself on a path where the government will need to continue to borrow a ton of yuan from Chinese citizens to buy (and hold) massive amounts of (depreciating) dollars in the foreign exchange market?

Opinions expressed on CFR blogs are solely those of the author or commenter, not of CFR, which takes no institutional positions.

42 Comments

Posted by Dave ChiangMay 20, 2007 at 9:59 am

Brad,

The Chinese economy is the recipient of an extremely loose monetary regime under the Bernanke Federal Reserve. While statistics to the general public by the Fed have been discontinued, broad M-3 money supply growth is estimated to be exploding at an annualized rate of 12 percent. Until I stop receiving an average of 3 credit card offers at zero percent interest in the mail each and every day, it is very hard to otherwise argue that money isn’t “cheap”. The US Economist community to date, has refused to acknowledge that the Federal Reserve bears primary responsibility for the numerous asset bubbles in the United States which has massively misallocated capital in the US Economy. Instead we are told an almost laughable narrative that the Chinese PBoC has somehow forced Americans to overconsume on gas-guzzler SUVs’ and million dollar McMansions from coast to coast. The Chinese PBoC has been trying with some success to mop up excess US dollar liquidity without any cooperation from irresponsible US monetary authorities. The Federal Reserve writes Economist Stephen Roach is a “serial asset bubble machine”. Simply stated, the loss of US global competitiveness from massive capital misallocation is certainly not the fault of the Chinese. Why should Chinese exports to the rest of the world be penalized with a higher yuan exchange rate for gross economic mismanagement decisions by the Federal Reserve.

Posted by Macro ManMay 20, 2007 at 12:04 pm

Dave, how is China the recipient of US monetary policy? Chinese nominal rates are lower than US rates. Chinese money growth is higher than US money growth. The Fed buys zero Chinese government bonds; China buys hundreds of billions of US bonds.

To portray PBOC as some noble warrior battling against irresponsible Fed policy is a joke. In a 14%/ 15% nominal growth economy, PBOC has set policy such that it and the government can borrow at zero real inte5rest rates. How is that possibly the Fed’s fault? PBOC is currently the single largest perpetrator of excess liquidity in the world today via their leviathan FX reserve accumulation and consequent price insensitive purchases of government bonds of developed markets.

And Dave…if China feels that they somehow are the recipient of inappropriate monetary policy from the Fed- just de-peg and let the bloody currency finds its true value.

Posted by GuestMay 20, 2007 at 1:11 pm

Trying to tie in from Brad’s observation in the previous post, that ‘China’ “…has clearly put upward pressure on the price of a host of commodities…and things, like houses…” (and presumably other types of real estate like forests and agricultural lands that are being used to build more houses), along with some of the responses, if we might also spend more time assessing associated pressures on other economies, asset classes and correlations, rather than focusing so much on China-U.S.. I agree with ‘flipper’ that we should also pay more attention to base metals.

But my interpretation of this: “…Among emerging markets, 42 percent of investors in the survey said they viewed China most positively…” http://www.washingtonpost.com/wp-dyn/content/article/2007/05/20/AR2007052000134.html is that “positively” may refer to ‘growing expectations for sudden, violent RMB appreciation’, rather than China’s overall economic prospects or relative stability as compared with other ‘investment’ options.

Posted by StormyMay 20, 2007 at 1:40 pm

I think it is important to assess China’s long-term plans, as they are laid out in the yearly modernization report. By 2020, China hopes to be fully industrialized; by 2030, to have a mature industrialized economy, moving towards a digital and knowledged based economy. By 2050, China wants the minimum wage to be about $1300/month, measured in 2002 U.S. dollars (even the writers of the report think this goal is highly improbable).

A little loosing of the band is not much to get excited about. Clearly, the Chinese are using the U.S. credit binge as a fulcrum to leverage more rapid industrialization. And, with the help of multinationals, they are doing quite good at it.

At some point, one or more factors will come into play:
China will have to confront the power of the multinationals (create more of its own…whatever) Otherwise, it will just be a factory on a golden leash. Evening the tax rates between indigenous and foreign firms is a step towards this end.
Markets–both the U.S. and the European–will simply not be able to continue buying at the rate China and other developing countries produce. Credit collapse? And, despite all the hype, China is far from being a consuming nation.
Peak oil will push everyone over the edge. Saudi Arabia is no longer producing as predicted.
Global warming concerns will but a real damper on coal energy. China is building coal plants at an alarming rate, just to meet its energy needs. (562 new plants by 2012–using old technology.)

Anyone can point fingers: It’s the U.S.; it’s China. Each is using the arrangment to its own advantage. The U.S. is a bit more myopic, thinking that only the stock market is the true measure of things. If China does not deliver cheap labor and other goodies, there is always other developing countries waiting in the wings: Vietnam, Colombia, Peru, India, the Philippines…. The hope is, of course, that China will be the BIG market eventually. But trying to time that arrival while still keeping an eye out for good cheap labor is going to be a bit dicey.

But I wouldn’t place my bets on China, either. It has to keep the multinationals and the FDI in play–keep the package attractive while it makes its move. Again, a bit dicey.

Frankly, I think China is a bit too late to the party: Energy and the environment will see to that.

Posted by EmmanuelMay 20, 2007 at 2:21 pm

Take it easy on Dave-o-nomics. The endgame is nigh for token revaluations, anyway. Here’s what will likely happen. First, the Strategic Economic Dialogue next week will come to naught. Next, whether Treasury declines to label China a currency manipulator or not, Congress will be at work on the legendary veto-proof, WTO-legal legislation on yuan undervaluation. Get ready, folks, it’s coming down the pike. Believe me, it ain’t gonna be pretty for either side if it passes, but better to let these imbalances come to a head now rather than later. I’m bored silly with all this showboating. Put on yer gloves and duke it out.

The US-China economic death match will soon be underway.
As Vice-Premier Wu Yi said, “If you want a fight, let’s fight.” [Ladeez and gentlemen...in the Red(s) corner, weighing in at $1.2T in reserves...]

Posted by krMay 20, 2007 at 3:40 pm

I’m with E. I think Paulson has said as much – i.e. If you guys [Congress] insist on a protectionist stance, then prepare yourself for what comes next. As if $4 gas wasn’t enough fun. Is there a back-of-the-envelope calc in terms of cost increases for the average consumer with a 10% annual RMB appreciation? My hunch is that this would be instant recession but it would be nice to back that up with numbers.

Posted by bsetserMay 20, 2007 at 5:14 pm

a 10% RMB revaluation wouldn’t have a huge direct impact. Goods imports from china are 2% of US GDP, more or less (i haven’t looked up the number recently, but it is roughly right). a 10% revaluation that is passed on fully to the us consumer (most XR moves are not by the way — China, the US MNC, etc eat some of the change) generates a direct effect of 0.2% of US GDP. The big change in oil prices had a much bigger impact. hell, the change in the euro/$ and its impact on US imports from Europe was presumably larger.

If you want to do it in terms of aggregate consumption, goods from China are maybe 3% of total consumption (consumption is 70% of GDP, imports from china are around 2% of GDP), so the cost increase is 0.3% of consumption. in terms of the impact on the average consumer, the calculation would be more difficult — but that should give some ball park estimate.

the real trouble would come from a fall off in financial flows from China/ any market reaction in the US, not any direct impact.

incidentally, this is exactly the same logic used to argue that Chinese competition hasn’t had a big impact on US wages — tis hard to get a big impact out of 2% of GDP. To get a bigger impact, you need to assume that there are some indirect impacts …

Posted by QingdaoMay 20, 2007 at 5:50 pm

When Chinese Premier Wen Jiabao said publically that the Chinese economy was “unstable, unbalanced, uncoordinated and unsustainable” he meant exactly what he said. The “exit” will come from either a domestic economic crisis or “imported” via American tariffs; the Central Committee probably prefers the latter, no doubt because they would gain political legitimacy for another generation.

Posted by bsetserMay 20, 2007 at 6:35 pm

Qingdao — interesting point. the central committee may get its wish then. somewhat scary. the impact of us tariffs on China’s markets may be more important than the impact of us tariffs on US markets (or consumers) right now.

Posted by GuestMay 20, 2007 at 7:39 pm

Dear Brad,

I agree that if the Chinese (who are followed by numerous other central banks) continue to allow only minor changes in the dollar peg, they will need to borrow ‘a ton of yuan’, but I also believe that the threat of continued widespread global inflation, not just in commodities, real estate and collectibles, is underestimated. The Chinese intervention policy is inflationary, globally, as is any intervention policy that results in increases in foreign exchange reserves. The sterilization policy is a temporary palliative that, along with the global emphasis on ‘core inflation’ indicies, has obscured the underlying inflationary dynamics.

When the Chinese central bank intervenes it issues Renminbi, out of thin air, to buy dollars. This expands the balance sheet of China’s central bank and the Chinese banking system. If the central bank issues sterilization bonds to sop up the additional money base created by the intervention, this does not shrink the balance sheets; it changes the central bank’s liability from deposits to renminbi bonds, which now offsets the increase in assets, the newly purchased dollars.

The renminbi deposits purchased with the intervention bonds are not the accumulations of Chinese citizen savers. They are not to be considered ‘savings’; they are the same (inflationary) renminbi deposits created during the recent currency intervention to buy the dollars.

The newly issued sterilization bonds, which are an abligation of the Chinese government to the bond purchasers, finance the increase in dollar reserves and the purchases of dollar securities. They can be issued in infinite quantities, as long as Chinese citizens, (and the Chinese banking system), are willing to hold them, at prevailing interest rates, and confidence in their value (and Chinese bank deposits) is maintained in terms of real goods and services.

The Chinese (and other) central bank(s) purchases of bonds drive global interest rates down to levels that private borrowers find inexpensive; global credit growth accelerates. (Global bond inssuance has been facilitated by derivatives, credit default swaps and other financial innovations that have compromised the constraints that otherwise would have come into play from commercial bank reserve requirements.) This is the inflationary mechanism outlined by Jacques Rueff in the 1960′s during the gold exchange standard period.

The issuence of the sterilizion bonds may suppress, for a limited time, the domestic inflationary consequences of China’s intervention, and Chinese export prices, but not the international inflationary consequences. In time, inflation in global commodity and asset prices, (which are a result of central bank intervention policies,) begins to impact Chinese domestic price trends. In order to maintain the dollar peg, the Chinese authorities are pressured to raise interest rates–on bank deposits, and on intervention bonds–to prevent a run from bank deposits and accellerating inflation. But it won’t work. Either a major revaluation or a major inflation in China will ensue. As you imply, there is no other exit strategy. Chinese export prices are headed up. Global inflation is already underway.

The FT published a letter by me on this topic Nov 2,2005. It can be retrieved by searching the FT for: Letters to the editor: Low interest rates

David K. Richards

Posted by flipperMay 20, 2007 at 11:03 pm

Brad, and what exit is possible for China and Japan? Dump their paper in the market and stop financing US? It will be a hard landing for US and the global financial system. Both sides will lose in the short run. And China and Japan lost on their reserves anyway -if they move from US bond to anything else – materials, stocks, land – it’s already have been inflated.

Neo classical theory implies that income per capita should converge, but who said it will be a growth path for everyone?

US just lives beyond it’s means and takes on more and more debt. May be US should stop it’s effort to become the world policeman, clean it’s books, spend less on military and save more?

Otherwise it all will end really nasty, when the biggest debtor has also the biggest military and political power.

Posted by amateur econMay 20, 2007 at 11:21 pm

Every night Americans should give thanks to the corrupt, shortsighted Chinese society. To think 900 million rural Chinese have no money, no health care, no free public education and must send their young daughters to work 80 hour weeks in sweatshops in gleaming, far off cities just to send a pittance of monetary support back to the village while their govt in Beijing sends us 100s of billions of dollars in goods so we can enjoy our short time on earth.

May God bless the Chinese. Party on.

PS, Let their Central Bank buy all the American “private equity” funds they want. We can always print more dollars to buy them back. If they won’t sell we can nationalize them. True capitalism is dead anyway.

Posted by HZMay 21, 2007 at 12:26 am

Rehi after a long while. Good to be able to post again.

A couple of points to consider as far as the potential impact of a trade war goes:
1) The stock market is almost entirely supported by overseas growth right now (sure a large part of that comes from Europe). A protectionist stance is a no vote on that business model and one can only imagine the impact on the valuation.
2) Your estimate of impact is based on financial valuation. U.S. economy is a lot more leveraged than China’s in many aspects: leverage on the goods economy (service to goods ratio), leverage on operations (think J.I.T. manufacturing), leverage on debt (savings/investment ratio). Leverage is amplification, on the up side and on the down side. So even if protectionists don’t give a hoot about 1), they should think and prepare for 2). Otherwise it will be deja vu all over again (as in Iraq).

I think a bit of domestic inflation in China is a good thing. Domestic consumption seems to be having a significant pickup. I also believe past inflation data had underestimated true inflation felt by the consumers there because of the quick change in consumption mix. On a PPP basis Yuan is coming close to USD in larger cities in China. But of course China has two economies.

BTW, China still has about 13% (VAT rebate) latitude of adjusting export preference before resorting to currency valuation adjustment. I don’t know why everybody seems to ignore this obvious better tool for adjustment except for the Chinese government. I think they should remove this much more aggressively than they have so far been doing. It is a big administrative headache for them anyway, so it will truly be two birds with one stone.

Posted by HZMay 21, 2007 at 12:33 am

On the household deposits, one should think that it has almost no impact on cost of sterilization. Total deposits as measured by M2/M3 are a function of debt/leverage and base money. M2 is going up >16% a year. If household portion of it is going down, commercial/government deposits must be going up. But commercial deposits earn less interest so cost of sterilization is lower if anything.

Posted by dfMay 21, 2007 at 3:56 am

China is now buying US assets (with no voting rights !!!) that s the main change.

And also the chinese stock market is taking speed.

Posted by dfMay 21, 2007 at 5:08 am

dave is really a strange fellow … Always “defending” china as if it was under attack …
Wake up Dave, china is the one with the reserves the surplus and the undervalued currency.
That does not mean the USA are to blame for having started the deregulation game, nor that Japan is not even worse than China. After all Japan is the country that reinvented mercantilsm in earnest.

Simply stated we need higher asian currencies higher taxes on oil for planes and boats and we ll get some reindustrialisation in the west and some relocalisation of the economies.
It s in the cards anyway.

See next : Dave Chiang argues that there is no stock market bubble in Shanghai or that if there is one it is because of Bernanke

Posted by dfMay 21, 2007 at 5:11 am

btw just look at the US housing market and u can know deflation is in the card it won t be long till no one receives credit card with 0% rate in the mail, and it won t be long till 0% rate will mean a 3% real rate in consumption goods and a 10% real rate in capital goods

Posted by ACMay 21, 2007 at 5:32 am

Brad asks what China’s exit strategy is.

I don’t see why they should have such a strategy, if the US did not keep a preassure on them. If they could do whatever they want without any external preassure, why should they worry about the size of the reserves. In fact why should they worry about the loss on those reserves? They could simply write the entire amount of reserves off as a loss, if in the next 10-30 years they can lift up another 300 million into the middle class, can occupy all the export markets in the world (especially in Europe in the short term), can master all high-tech and can produce everything from microprocessors to wide-body aircraft on their own, can attract the 100,000 people who studied in the past at the best universities of the world to go back to China, etc. Why would the loss of any trillion USD matter if they have such great possibilities, if they think not within a few-year horizont, but instead within a few-decades or a few-centuries horizonts.

Posted by GuestMay 21, 2007 at 6:22 am

Whether inflation makes it a tad more difficult to lift another 300 million from poverty? And not just in China: Steve Brice, chief Middle East economist at Standard Chartered Bank in Dubai: “We were expecting a revaluation not a currency basket. A revaluation gets in the way less of monetary union. One of the criteria of the monetary union was a common monetary policy. Now of course we don’t have that. There is a lot of uncertainty in the market…” http://www.gulf-times.com/site/topics/article.asp?cu_no=2&item_no=150424&version=1&template_id=48&parent_id=28

Posted by GuestMay 21, 2007 at 6:39 am

flipper – are you suggesting that the U.S. should simply stop selling debt to China? or cut back on its military spending when everyone else seems to be busy increasing their own which, I guess, also involves an increase in the demand for, and purchase of U.S. military exports… Maybe we should be paying more attention to that market too

Posted by koteliMay 21, 2007 at 7:23 am

Guest, I think that flipper has some point:

THE UNITED STATES. WHERE DO YOUR TAX DOLLARS GO?

Military, health and interest on the debt consume two-thirds of every income tax dollar.

The median income family in the United States paid $3,736 in federal income taxes in 2006 . Here is how that amount was spent:

The chinese need an exit policy because supposing they get to the point where they build 100% of all manufactured goods in the world, may be they ll go tired of supplying them for free to the rest of the world.

Posted by CharlieMay 21, 2007 at 7:36 am

Brad,
I’m glad you wrote about money being pulled from banks and invested in the stock market. I realized, like you, that this would make sterilization efforts more difficult. I think it’s going to have another bad side effect. Banks can continue to hide bad loans as long as reserves are growing quickly. Once reserves start shrinking, hiding bad loans is much more difficult.

One option that Japan is using that China can’t use is to drop interest rates to near zero. The Japanese central bank no longer needs to buy USD to keep their currency low. Hedge funds take care of this for them via the carry trade. If you want to know the size of the Yen carry trade, it must be about the same size as Japan’s trade deficit with the US. Otherwise the Yen wouldn’t be stable in USD.

China can’t drop interest rates to near zero. It would overheat their already overheated economy. Plus, I’m not sure they could get enough risk takers to borrow and cover their trade surplus since, I think, the risk of Yuan appreciation in greater Yen appreciation.

I think the ultimate end game is going to be an enormous amount of bad loans on the books of Chinese and Japanese banks. The bad chinese loans will be to internal borrowers, while Japan’s will be to hedge funds who invested in US debt. I suspect the central banks of both countries will bail out the banks with a series of low interest bridge loans. Both China and Japan have setup environments where it is impossible for a bank to be economically profitable.

Posted by bsetserMay 21, 2007 at 7:46 am

Why does China need an exit strategy?

Simple: because right now an ever larger share of Chinese savings needs to be lent to the US to sustain the status quo — it isn’t a constrant (future) costs, but a rising one. The future losses on that lending is also increasing, as is the internal difficulties sterilizing the reserve growth. Japan got a bubble economy with loose monetary policy to offset yen appreciation, china looks close to creating a bubble economy with loose monetary policy to avoid yuan appreciation.

and the United STates internal problem over the distribution of the gains from trade with china (all blackstone and condo flippers, very little for the median worker with fairly flat real wages despite productivity growth) will soon become China’s problems. China constantly argues that the US has to take into account China’s political needs for employment. But the US also has political needs –

HZ — good to hear from you again. sorry about the period when comments required registration.

Posted by RebelEconomistMay 21, 2007 at 8:09 am

Brad, D.K.Richards,

It seems to me that whether China can expect to lose on its intervention (short of deliberate repudiation of course) and whether its intervention represents mobilisation of Chinese savings depends on whether the banks are willing buyers of sterlisation bonds. If there are insufficient projects available (to the Chinese) in China with a risk-adjusted return as good as offered by the US consumer borrower, then the intervention would represent facilitation of investment flows out of China that would occur anyway.

Do you know of any evidence about the motivation for Chinese saving and bank purchases of sterilisation bonds? How far is it voluntary?

Posted by ACMay 21, 2007 at 8:10 am

Brad — I understand that China suffers big losses in money on its current policies, and these losses will grow in the future. I just think that there are gains other than those you can measure in money. For example, in the past 30 years China built up this huge reserves (in the past 10 years, really), and at the same time 300 million Chinese are now in the middle class, thanks to the policies they run in the past 30 years. What is more valuable? I think that the latter, even though you cannot put a price-tag on it. If I were China, I wouldn’t worry too much about losses until on the other hand I have more important gains, which cannot be measured by money. How much is it worth, for example, if 100,000 Chinese students who received the best education in the world return to China, and use their talents and knowledge for China’s benefit and not for the US’s benefit?

Posted by gheorghiusMay 21, 2007 at 8:15 am

I agree, China’s monetary policy has not changed much – till now. These recent moves – such as broadening the band – are typical of a monetary authority who is desperately looking for a way to resist market pressure on its fixed exchange rate, before giving up. In Nov 2006 and in early 2007 I painted a “June 2007 scenario” suggesting a forthcoming sudden strong RMB appreciation. I expected the RMB revaluation to be anticipated by precisely these kinds of moves (including stronger credit restrictions, etc.).

Maybe appreciation will occur in September 2007 instead of June, given the resilience of US interest rates and the consequent Yen weakness. It doesn’t matter.

But China’s logic is not always well understood. Paulson’s pressures don’t weight too much right now, compared to monetary pressures, and they will not determine, ultimately, China’s exrate. China has serious domestic (over-saving-and-investment) problems now, caused by a flood of foreign money. This will trigger soon or later (sooner rather than later) a sudden exrate move. The pressure is becoming too high: it’s only a matter of time.

Posted by Macro ManMay 21, 2007 at 8:23 am

RE, the primary rationale for buying sterlilization bonds is ‘moral suasion’, aka ‘the tap on the shoulder’. Banks face lending quotas from the PBOC, which limits their loan assets to a relatively small portion of their deposit base liabilities. Fortunately, deposit rates are kept artificially low, even with the 27 bp hike, so banks can still earn a margin by buying sterilization bonds and paying statuatory interest rates on deposits.

In a sense, though, deposit rates represent a minimum lower bound for the yield on sterilization bills, as banks won’t lock in negative margins. Most large banks still retain healthy excess reserves and so do not necessarily need to change behaviour when the RRR increases. Some of the rural banks, on the other hand, do need to alter their practices with an increase in the RRR…which generally means buying more sterilization bonds as they increae reserves, as I understand it.

Posted by GuestMay 21, 2007 at 8:42 am

AC – do you honestly believe that educated people residing in the U.S., whether or not they are U.S. citizens, work only for the “U.S.’s benefit”? and that educated Chinese people work only for China’s benefit, but only when they are ‘in China’?

Posted by GuestMay 21, 2007 at 9:43 am

Global political rhetoric may be centered on jobs, but how much does employment contribute to the average person’s capacity to: buy a home, particularly in major urban centers which presumably should have the capacity to create jobs, such as New York, Beijing, Shanghai, Moscow – or London – “…Prices in central London are now over 33 per cent higher than they were a year ago, and in some locations growth is over 40 per cent…” http://firstrung.co.uk/articles.asp?pageid=NEWS&articlekey=5108&cat=44-0-0

or build retirement income?

“…different parts of the government have invested heavily in shares – often illegally – during the recent boom in the mainland market and could be exposed to losses if there were a crash… Shanghai is only just recovering from a major corruption scandal last year… after it was revealed that a group of senior officials had siphoned off one-third of the city’s pension fund, partly to invest in high-profile real estate projects…” http://www.ft.com/cms/s/6087ff16-06fa-11dc-93e1-000b5df10621.html

Posted by RebelEconomistMay 21, 2007 at 9:47 am

Macro Man,

Thanks for the previous answers, but may I pose another question…..how are Chinese deposit rates kept artificially low? Is that not the expression of a high propensity to save?

One wonders why the Chinese banks would want to lend to the private sector anway, given the high level of bad debts. I presume though that the reason why the government limits bank lending is that they are concerned about excessive development, pollution etc.

I am trying to understand how this works. It seems to me that the Americans’ best way of persuading China to change is if they can point to internal distortions in China that are costly to the Chinese people. There has to be more to this than straightforward exchange rate manipulation, because in most countries, domestic inflation or sterilisation costs would make it unsustainable.

Posted by Macro ManMay 21, 2007 at 10:06 am

RE, deposit rates are set by PBOC, not by individual banks in competition. So one of the measures taken last Friday was to raise that deposit rate by 0.27%.

As you correctly note, there are negative externalities to unfettered investment spending, such as misallocation of resources, pollution, future costs of bad debt cleanup, etc. This is one of the reasons why bank lending is capped, which in turn has helped generate high levels of corporate savings.

Household savings, while large, has not grown to the same degree as corporate savings in recent years. But one of the rationales for high household savings is China’s poor demographic profile (one child policy = few descendends to support one during one’s golden years), and another is the lack of a social safety net (medical care, unemployment benefit, state pension, etc.) This is one of the reasons that I would rather see China spend its $ trillion on a safety net instead of Treasury and Agency bonds. It could, in the fullness of time, reduce the domesti propensity to save.

Posted by bsetserMay 21, 2007 at 10:35 am

RE — there is no evidence of private Chinese demand for lending to US households. Hence the low take up of the QDII when it was limited to bonds. Real returns on Us housing bonds (or loans to US banks) are lower than the real return on RMB deposits at 3%, and RMB deposits also win if there is a bigger than expected reval so they have some option value. $ by contrast are worth less in that scenario. Reserve growth simply isn’t subsituting for a private outflow that would occur otherwise at current exchange rates and int. rates.

American consumers are not irrational; they react to monetary and fiscal policies. When interest rates are excessively low, and tax policy is geared at encouraging consumer spending, people spend until they drop. A weak dollar further discourages savings, as those savings erode in value. But given America’s current-account deficit, it urgently needs policies in place to encourage more savings and investments to reduce the pressure on the dollar.

A strong currency is also a matter of national security. Politicians are complaining that foreigners hold too much of US debt. Paulson has rightfully said that by all means, the US should try to maximize the demand for US debt to minimize the interest rate Americans have to pay; this includes allowing foreigners to buy the debt. The solution, of course, would be to curtail the supply of debt. In plain English: cut your spending, or foreigners will dictate in due course what you may spend your money on (that would be interest payments to them).

A strong dollar and US interests
By Axel Merk

It seems that to qualify for the job, US treasury secretaries must be able to recite, “A strong dollar is in the interest of the United States,” any time and anywhere. Robert Rubin, treasury secretary during the second half of the 1990s, was highly credible when he said it. However, when secretary John Snow uttered the same words, the ritual had been diluted to providing the appropriate sound bite to the media.

Henry Paulson, successor to Snow and current treasury secretary, is a straight talker, but knows that his job comes with

what amounts to a marketing responsibility. In the meantime, investors are at a loss as to what the US policy toward the dollar truly is; there seems to be a disconnect between what ought to be in the country’s interest and what current policies promote.

Abby Joseph Cohen, chief investment strategist at Goldman Sachs, who may be best known for her perpetual appetite for increasing price targets for US markets, called the weak US dollar the “icing on the cake”; she was referring to the potential positive effect on stock valuations given that foreign earnings translate into higher earnings for US companies conducting business abroad.

The US Congress would like to pressure the Chinese to allow their currency to appreciate, ie, to weaken the US dollar versus the Chinese yuan. If the Chinese were to oblige, it would almost certainly increase the cost of goods the US imports from China; and because the Chinese recycle a lot of their dollar holdings into US Treasuries, any move on behalf of the Chinese to reduce their dollar holdings would put upward pressure on US interest rates (because of the inverse relationship between bond prices and interest rates).

Breaking with the long-standing tradition of leaving all discussions pertaining to the dollar up to the Treasury Department, Federal Reserve chairman Ben Bernanke has not shied away from commenting on the impact the dollar has on the economy. Bernanke, who considers himself a student of the Great Depression, has said: “To understand the Great Depression is the Holy Grail of macroeconomics.” He laments in his analysis of the Great Depression that keeping up the value of the dollar (by preserving the gold standard) increased the hardship of the people.

But the treasury secretaries are correct: a strong dollar is in the interest of the United States. For starters, Americans live in an interconnected world, and a weaker dollar makes the US less competitive. Also, a weaker dollar won’t rebuild industries that have been lost to Asia. Sure, profits generated abroad through services provided abroad translate to higher dollar earnings, but the positive impact may be limited to a quarterly earnings release. Just as dollar cash is less competitive when it is devalued, so is a stock price when measured in a weak currency. Foreign companies can use both their stronger currency as well as their stock prices valued in hard currencies to acquire US assets and enterprises.

As the dollar weakens, America’s purchasing power erodes. Look at the price Americans now pay at the gasoline pump if you believe a weak dollar does not have an impact. The Organization of Petroleum Exporting Countries has made it clear that its price target for oil floats upward as the dollar weakens.

American consumers are not irrational; they react to monetary and fiscal policies. When interest rates are excessively low, and tax policy is geared at encouraging consumer spending, people spend until they drop. A weak dollar further discourages savings, as those savings erode in value. But given America’s current-account deficit, it urgently needs policies in place to encourage more savings and investments to reduce the pressure on the dollar.

A strong currency is also a matter of national security. Politicians are complaining that foreigners hold too much of US debt. Paulson has rightfully said that by all means, the US should try to maximize the demand for US debt to minimize the interest rate Americans have to pay; this includes allowing foreigners to buy the debt. The solution, of course, would be to curtail the supply of debt. In plain English: cut your spending, or foreigners will dictate in due course what you may spend your money on (that would be interest payments to them).

A weak currency is inflationary. Wall Street analysts focus on “core inflation” excluding food and energy; most have forgotten that the reason food and energy prices have traditionally been ignored is their volatility. But these prices have been moving upward for years now, with US Energy Secretary Samuel Bodman already forecasting high gasoline prices for next year. Given the new love affair politicians have with ethanol, food based on corn (maize) is bound to be increasingly expensive. So far, we have only heard of the Mexican tortilla crisis, where Mexican consumers are complaining that their corn-based tortillas are no longer affordable; but US food prices are also affected, as corn (and notably corn syrup) is in countless food items.

Globalization and the Internet have held back, but not eliminated, inflation. Items Americans don’t need – mostly those imported from Asia – have experienced tame inflation (mostly because of Asian overproduction, partially a result of their weak currencies). But just about everything Americans do need, from health care to education and local craftsmen, has experienced significant inflation.

Preserving purchasing power should be in the interest of every policymaker, and in particular be in the interest of the Federal Reserve. But policymakers allow eroding purchasing power to act as a substitute to finding solutions on how to pay for obligations ranging from government debt to social security. Once a country is hooked on growth through inflation, it is difficult to change bad habits. Italy is still struggling to cope with the rigidity of the euro after decades of inflationary policies.

The Fed has allowed an unprecedented credit expansion to take place. Bernanke seems to believe there is no need to impose tighter credit to fight excesses that have been building up in the economy. However, if one allows a credit bubble to take place, one must also be willing to allow a severe recession or depression to take place to rid the economy of excesses that have been built up.

Those who are most concerned about the dollar do not believe the Fed will allow such a correction to take its full course; there is already talk of a Fed interest rate cut in a few months. In our assessment, the Fed is rather concerned that a credit contraction combined with high levels of consumer debt could create a Japanese-style deflationary spiral; to avoid having to deal with deflation, the Fed should induce inflation.

Posted by RebelEconomistMay 21, 2007 at 11:41 am

Macro Man, Brad,

So, from your answers, it does seem that you agree that Chinese intervention is at least partly motivated by a desire to redirect a very high peoples’ propensity to save into overseas capital markets, where risk-adjusted, environmentally-adjusted returns to them are better.

As I have said before, I do think that there is a strong case for the Chinese to widen their currency basket to direct more saving into euros etc, but you seem to be against intervention in general, so what would you have the Chinese do with their savings? (I am not clear how Macro Man expects them to spend dollars on a safety net, other than investing them in the US).

Posted by bsetserMay 21, 2007 at 12:05 pm

I would take steps to reduce high corp savings (mroe dividend distribution) and run a fiscal deficit to use household savings to meet domestic needs rather than just subsidizing us households — i don’t think the current policy is an optimum response to high savings (and in some ways, by artificially propping up corp. profitability and business savings, it has contributed to the problem not solved it)

Posted by GuestMay 21, 2007 at 12:34 pm

It’s been mentioned here before, and we are reminded again in this morning’s FT article, but there may be some significant issues in the management and allocation of social safety net funds in China. Is it possible that social safety net cuts in nations like Britain and the U.S. could be justified as a measure meant to force household saving?

As for the military spending, if anyone knows how much of America’s military budget is spent outside of the U.S. My guess would be that a substantial cut may be felt beyond it’s borders.

Posted by Macro ManMay 21, 2007 at 1:05 pm

RE, my belief is that instead of PBOC issuing sterilization bonds to buy Treasuries (and Bunds, and Gilts, and investments in Blackstone, etc), the central government should issue debt to pay for medical care and workers’ benefits and a pension scheme for the elderly.

I don’t think the intervention policy was conceived or is currently run as a deliberate instrument of nationalizing overseas investment (though I’ll concede that maybe it is becoming so.) I think it was conceived as a way of batting foreign capital inflows into China back from whence they came. I very much believe that if PBOC, et al knew in 2003 what the world would look like today, they would have developed a different FX policy.

Posted by Dave ChiangMay 21, 2007 at 1:16 pm

Brad,

The simplest solution to resolving U.S. current account deficits is to reduce consumer spending and increase savings by raising interest rates from abnormally low “real” inflation adjusted levels. The current 5 percent interest rate does not adequately compensate savers for their capital. The Federal Reserve is unwilling to obey its official legal mandate for price stability, any talk about that the Chinese should emulate irresponsible US monetary policy by running equally large government deficits is absurd. The US should get its own house in order before scapegoating others.

Posted by RebelEconomistMay 21, 2007 at 4:10 pm

Macro Man,

If the capacity exists to do what you suggest, it sounds like a reasonable idea to me. There do seem to be people in China who could benefit from resources spent on social security, such as those who lost their medical care when laid off by the SOEs. Perhaps the Americans should focus discussion on such issues. The Chinese do not explain their policy very well.

Of course this should not excuse the Americans doing what they can to put their own house in order.

Posted by dfMay 22, 2007 at 4:47 am

Dave you wrote

Brad,

The simplest solution to resolving U.S. current account deficits is to reduce consumer spending and increase savings by raising interest rates from abnormally low “real” inflation adjusted levels.

This is :
Illogic
False
unsuited to the point

a this is illogic because nobody ever proved that higher interest rates lead to higher savings. Try to explain saving rate discrepancy accross countries by interest rate level I wish you good luck. Try to explain it within country, it may work a bit more, but that s not the main channel. I believe fiscal evasion is a key driver of low savings in the US case for instance. (borrow to invest in a house). deregulation of the credit business is another reason.

False :
real interest rates are already above the long term historical mean. Historically real interest rates have always been around 1%. Only since the 80′s have real rates been higher.
No one should make money by doing nothing anyhow.

Unsuited to the argument :
Chinese rates are LOWER than those of the USA. WHy don t THEY raise rates, thus cooling the investment rate, cooling export growth and helping reduce the deficit.
If they would raise rates, this would automatically attract capital, they would have to raise the value of the RMB and everything would be OK.

There is no problem with the monetary policy in the USA there are problem with the fiscal policy and with the reglemention of business activity especially in the financial sector. If the USA would only go back to administrative curtailment of credit, they would be able to rebalance their economy somewhat.
the right policy mix is tons of dollar emission by the central bank and strong curtailment of credit activity by private agents.

Posted by dfMay 22, 2007 at 4:53 am

No comment on blackstone deal ?
Nothing on the exhuberance in the shanghai stock market ?
Is not this inflation in earnest, albeit in capital goods prices ?